Hello and welcome to McDonald's April 19, 2013 Investor Conference Call. At the request of McDonald's Corporation, this conference is being recorded. Following today's presentation, there will be a question-and-answer session for investors. (Operator Instructions)
I would now like to turn the call over to Mr. Chris Stent, Senior Director of Investor Relations from McDonald's Corporation. Mr. Stent, you may begin.
Hello, everyone, and thank you for joining us. With me on the call are President and Chief Executive Officer, Don Thompson; and Chief Financial Officer, Pete Bensen. In addition, Chief Operating Officer, Tim Fenton will join us for Q&A. Today’s conference call is being webcast live and recorded for replay via phone, webcast and podcast. Before I turn it over to Don, I want to remind everyone that, as always, the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both documents are available on www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures.
And now, I'd like to turn it over to Don.
Thanks, Chris, and good morning, everyone. Despite mixed first quarter performance, McDonald's remains a daily destination for our 69 million customers around the world. The talented teams leading our business in 119 markets around the world continue to leverage their deep experience in a variety of operating environment.
Our strong system alignment has enabled us to remain focused on serving great tasting food and beverages in contemporary restaurants and at an affordable price because that's what matters most to our customers. These strengths combined with our diverse portfolio in terms of geography, menu and across day parts, enable us to build for the future while we remain focused on delivering in the short-term.
The challenging economic environment in which we're operating impacted our first quarter results. While there are mixed signs of a slow recovery in the U.S., significant headwinds persist as consumer confidence continues to waver. Persistently high unemployment rates and ongoing austerity measures in Europe and soft macroeconomic conditions in APMEA are pressuring consumer purchasing power as well.
And the informal eating out industry is either flat or declining in many markets around the world. Year-to-date March, our global comparable sales were down 1%. This reflects comparisons against strong prior year results that include an additional day due to leap year and last year’s favorable weather. Operating income was flat in constant currencies and EPS was $1.26, a 3% increase in constant currencies. While not unexpected, we are not satisfied with our first quarter results.
Even though our top line comparables will ease through the remainder of the year, macroeconomic pressures will continue, and we’ve also seen new challenges emerge in the marketplace like softer retail sales in the U.S. and the avian influenza outbreak in Asia.
So as we begin the second quarter, April global comparable sales are expected to be slightly negative. However, I am confident that we have the right plans in place to strengthen our business momentum for the long-term. We know we can’t control the external environment in which we’re operating, but we can leverage our scale and strength to aggressively pursue opportunities within our three global growth priorities to optimize our menu, modernize the customer experience, and broaden accessibility to brand McDonald’s around the world.
As I share an update on our performance by geography, I’ll provide examples that illustrate how local markets are executing their plans within the framework of our plan to win and these three global growth priorities. You’ll also see in some cases that we continue to make adjustments to generate the greatest impact in the current environment and drive long-term growth.
Let’s start with the U.S. where comparable sales for the quarter were down 1.2%, amidst the challenging eating out environment and operating income declined 3%. While our comparable sales were negative, we outperformed the competitive set and increased market share. This reflects our ability to continue differentiating our brand despite declines in IEO category. We continue to compliment Dollar Menu value news with a focus on core favorites and innovative new products. In addition to our annual focus on Filet-O-Fish during the Lenten season, we expanded the McBites platform to include Fish McBites.
Throughout the year, we will feature even more compelling new products in the United States especially in our four key growth categories of chicken, premium beef, breakfast and beverages. For example, Premium McWraps, a great innovation from Europe that we’ve begun to scale globally; Egg White Delight, a tasty lower calorie addition to our breakfast line-up and Blueberry Pomegranate Smoothies which originated in Canada are three delicious new additions that position us to continue growing sales and market share in the second quarter.
In Europe, comparable sales were down 1.1% for the quarter and operating income was up 1% in constant currencies. Results in Germany and France remain soft, while the UK and Russia continue to deliver. Across the region, we’re focused on building market share by reinforcing our value platform to offer compelling affordable products across all day parts and multiple price tiers. We build on that foundation by featuring premium products and promotions that encourage trade up and higher average check.
France launched Casse-Croute sandwich and drink combo for €4.50. It drove strong performance during the lunch day part by enabling us to compete with local bakeries through an appealing offer below the €5.00 price point.
In Germany, the €1.00 beef or chicken western burgers complemented (inaudible) and Stars of America promotional food events to contribute to results. Germany continues to refine its value offers across day parts in an effort to strengthen value perceptions for consumers who remain price sensitive in this challenging economic environment.
And in the UK, successful food events featuring premium products continued to resonate with our customers in this largely reimage marketplace. This past quarter promotions included the limited addition, Deli Choices, featuring the Cajun Crispy Chicken Sandwich. We also launched Chicken McBites in January as part of the UK tasters’ menu. This limited time offer further validates the global appeal of this great product outside of Australia and the United States.
Russia also continues to deliver solid results with its focus on breakfast and seasonal menu offerings that emphasize local taste, including spicy wraps and spicy rolls. While both the UK and Russia posted positive comparable sales for the first quarter and continued to grow market share, momentum in both markets has slowed relative to strong results in 2012. This is the effect of weaken consumer confidence in the UK and lower levels of inflation in Russia that limit our pricing power.
Now, let’s shift over to Asia Pacific, Middle East, and Africa, where comparable sales were down 3.3% for the quarter, while operating income increased 2% in constant currencies. We remain focused on aggressively driving top line performance and growing market share through continued emphasis on our value platforms by accelerating growth at breakfast and by enhancing service and convenience initiatives.
Breakfast remains a significant growth opportunity for us in APMEA. Today, a large percentage of the Asian population eats breakfast away from home. But our breakfast sales as a percentage of full day sales are only 11%. That’s less than half the U.S. average of 25%, which tells us the breakfast represents a significant growth opportunity in this region.
As part of a year long focus to get more consumers to think of McDonald's as a morning destination, 30 countries across APMEA participated in a National Breakfast Day promotion on March 18. 5,000 restaurants gave away 5 million of our great tasting and nutritious Egg McMuffins, and we significantly increased awareness and trial for our breakfast products.
Let’s turn to APMEA’s big three markets starting with Australia. Our focused efforts to balance value initiatives with promotional activities that encourage trade-up, positively contributed to first quarter results. Monopoly, which returned to Australia after a 13-year hiatus, drove Extra Value Meal sales and encouraged add-on purchases with game pieces strategically placed on drinks, fries, and deserts.
Japan’s performance for the quarter was negatively impacted by the difficult economy, a declining IEO industry, and ongoing consumer sensitivity to prices and promotions. Japan continues to evaluate and adjust its plans to complement existing value initiatives with new product news that drives long-term profitable sales and guest counts.
For example, January’s national Big Mac campaign resonated well with customers and was another step in our journey to rebalance our core menu pricing and promotion strategies.
In China, comparable sales decreased 4.6% for the quarter in part due to the residual effects of consumer sensitivity around the supply chain issue in the chicken industry. Even though our supply chain was not implicated. A diverse menu across multiple day parts, menu offerings, and price tiers enables us to offer a broad variety of affordable choices, which is especially critical in the current environment across Asia.
During the quarter, limited time offers, including the Mashed Potato Beef Burger and the Sausage Double Beef Burger positively contributed to performance. We’re also complementing our new-menu news in China with meaningful efforts to make McDonald's even more accessible to our customers. We continue to strategically add new restaurants with a focus on Tier 1 and Tier 2 cities, where we’re best able to effectively leverage our scale and our marketing strength.
Throughout APMEA, we are expanding our presence by building on the potential that exist in our brand extensions, especially delivery, kiosk, mid-café, and drive-through. As of March, about 50% of our restaurants are opened 24 hours and almost 20% offer delivery service to our customers.
As we continue to build on our firm foundation in every area of the world, our commitment to financial discipline has not wavered. We have a healthy balance sheet, the highest credit rating in the industry, and a robust business that generated $7 billion in cash from operations last year.
Our philosophy regarding the use of cash remains unchanged. Our first priority is to reinvest in the business to capitalize on our long-term growth opportunities. These include strategically developing new restaurants in certain markets, modernizing our restaurants, so they’re move relevant and appealing to our customers, and investing in initiatives like multiple order points or mobile ordering that increase the capacity and the convenience of our existing restaurant.
After reinvesting in the business, our second use of cash is our dividend. Our third and final use of cash is share repurchases. In the first quarter, we returned $1.1 billion to shareholders through dividends and share repurchases. In closing, we recognize the challenges inherent in the macroeconomic environment and do not expect to see any significant improvements in the short-term.
And while comparisons will ease as we move through the year, it is not likely that the global IEO industry will improve dramatically. This will continue to pressure our performance. Now more than ever, we remain focused on those areas within our control to grow market share and drive future performance. We know what we need to do and we are determined to keep getting better and sharing ideas, scaling proven successes and moving even more quickly to bring winning solutions to markets around the world.
I remain confident in our business. Our system alignment, our strategies, the actions we are taking position us well to successfully navigate this environment in the near-term while profitably managing the business for the long-term.
Thank you and with that, I’ll turn it over to Pete.
Peter J. Bensen
Thanks, Don, and hello, everyone. The pursuit of long-term profitable growth permeates the McDonald’s system and guides our actions from the way we staff our restaurants, to the investments we make in infrastructure and technology to build capacity, to the strategic decisions we make around menu offerings, pricing and promotions.
We entered the year aware of the challenges we’d face, growing comparable sales and margins. The steep first quarter lap, flatter declining IEO categories in many of our major markets and cost pressures throughout our P&L. Our business model is built around growing comparable sales to a level where we can realize margin leverage, when we don’t do that as in the first quarter, our margins are significantly impacted. The good news is that we have competed effectively in environments like this before.
For now, it is the market share battle and we are determined to continue making the necessary adjustments to maintain and grow our share, because that is how we will win over the long-term. There is no single solution for driving sustained growth in value creation; rather we are pushing forward on multiple fronts, guided by the three global growth priorities under our plan to win.
The adjustments are beginning to take hold. In the first quarter, we outperformed the IEO industry in several key markets, including the U.S. as Don noted earlier. With 81% of our global restaurants franchise, our profitability is driven primarily by top line sales. The total system life sales increased 2% in constant currencies, persistent expense pressures and negative comparable sales contributed to a 50 basis point decline in first quarter combined operating margin to 29.5%.
The largest driver of operating income continues to be our franchise margins, which rose $25 million to nearly $1.8 billion, a 2% constant currency increase. Consolidated franchise margin percent declined 60 basis points to 81.7% due to higher cost and negative comparable sales. Global company-operated margin dollars declined $58 million to $719 million for the quarter, a 7% decrease in constant currencies.
The margin percent decreased 130 basis points to 16.2% as average check growth was more than offset by higher labor, occupancy, and other operating costs. We expect margins to continue to be pressured throughout 2013, though margin decline to be less pronounced as sales comparison ease in upcoming quarters. In the U.S., company operating margins declined 140 basis points to 17.4% primarily due to higher labor and other operating expenses.
First quarter commodity costs were relatively flat. We expect increased cost pressure the rest of the year with a full-year increase in our U.S. grocery basket expected to be 1.5% to 2.5%. In terms of pricing, the U.S. entered the first quarter at about 1.5%. during the quarter, we’ve replaced about half of the 120 basis points of prior year price increases that rolled off. We will continue to closely manage our pricing decisions to maintain our value proposition as we strive to grow traffic and market share.
For the full-year, food away from home is projected to increase 2.5% to 3.5%, while food at home inflation is projected to be about 50 basis points higher. For the trailing 12 months ended March 31, food away from home was up 2.3%, while food at home was up only 1%.
Turning to Europe, company-operated margins decreased 80 basis points to 16.7% due to higher labor and commodity costs and increased depreciation related to reimaging. The UK and Russia together account for almost half of Europe’s total company-operated margin dollars. Europe’s grocery bill was up about 2.5% in the quarter. We expect a similar increase in second quarter with the full-year increase now projected to be 2.5% to 3.5%, slightly lower than our estimate in January. Across Europe, the average price increase at the end of first quarter excluding Russia was about 1.5%. The sluggish macro economic environment coupled with the soft IEO market will limit our pricing power for the balance of the year.
In Asia/Pacific, Middle East and Africa, company-operated margins declined 230 basis points to 14.6% due to the acceleration of new restaurant openings mainly in China along with higher labor, occupancy, and other costs throughout the segment. There is a heightened scrutiny around the quality of new store openings, ensuring that we are doing everything we can to optimize new store margins in this key growth segment.
G&A for the quarter increased modestly and was in line with our expectations. We are on track for full year G&A to increase about 2% to 3% in constant currencies, so there will be some variability between quarters. As indicated in January, the first quarter included a non-recurring tax benefit of nearly $50 million resulting in a tax rate of 30%.
Our full year guidance remains at 31% to 33%, which implies the effective tax rate will likely be at the higher end of this range in subsequent quarters. We remain committed to generating strong returns and enhancing long-term shareholder value through a balanced approach to growth, driving sales increases at existing restaurants and adding profitable new units.
We continue to exercise discipline as we allocate capital and make steady progress toward our global growth priority of modernizing the customer experience through our reimaging efforts. We expect to reimage more than 1,600 restaurants this year, including about 800 in the U.S., 450 in Europe, and 225 in APMEA. Through first quarter we have completed about 250 reimages globally.
In addition, we expect to complete about 200 rebuilds in the U.S. this year. Opening new units is part of our global growth priority to broaden accessibility to our brand. We focus on strategically growing at select number of markets to have a significant potential and can generate attractive returns over the long-term. We are on track to open between 1,500 and 1,600 new restaurants this year, including about 500 an affiliated and developmental license markets.
Lastly, let me touch on foreign currency translation, which negatively impacted first quarter results by $0.01. At current rates which reflect the recent strengthening of the U.S. dollar, we expect second quarter EPS to be minimally impacted with a full-year negative impact of $0.01 to $0.02.
As you know, this is directional guidance only, because rates will change as we move throughout 2013. The external challenges we face in 2013 are in many ways similar to last year, low consumer confidence in shrinking disposable income negatively impacting consumer demand coupled with continued pressure across many expense categories.
We believe we have made the appropriate adjustments to fortify our near-term performance and we remain diligent about monitoring the environment and making further adjustments as we move throughout the year.
I’m confident in the future of our great brand. McDonald's has increasingly modern restaurants in outstanding locations around the world. Best-in-class franchisees and suppliers and dedicated company employees, all aligned to drive long-term enduring profitable growth for our system and shareholders. Thanks.
Now, I’ll turn over to Chris to begin our Q&A.
Thanks, Pete. I will now open the call for analyst and investor questions. (Operator Instructions) The first question is from David Palmer of UBS.
David S. Palmer – UBS Securities LLC
Good morning, guys. Two part question on Europe. You described there was a slowing going on in that market, how are you – can you just generally describe how your marketing plans are this year? How are you going to adjust this sluggish environment? I recall, last summer, you were tinkering value menus particularly in Mainland Europe market. And secondly, as you are getting closer to the end of this curve at least on the interiors in Europe, would you consider or are you thinking about refranchising that market further to be maybe more or like the U.S.? Thanks very much.
Hi, David and good morning to you. There are several different points, I guess, in your question there. First of all, what have we done in Europe? Last year, we began to talk about a couple of the markets that we felt we needed to have additional focus on, those markets in being France and Germany. We talked about the fact that the southern division of Europe was really going through tough macroeconomies and that remains the same today.
However, what we have done is, in the market of France, we have changed and fortified our value offerings. We talked about Casse-Croute this morning. They solidified Petit Plaisirs. They’ve done several things and that's why we’re gaining share in France. If you look at the southern division, the southern division as a market, which includes Spain and Italy, and Portugal, those markets are also gaining share. So we have been performing – we’re performing well relative to the overall marketplace. However, it is very soft consumer confidence there.
Relative to refranchising, what we have continued to do as we always do is look at our overall company-operated portfolio and determine whether or not we have opportunities to continue to improve that first or we have opportunities in terms of leveraging G&A, leveraging scale, improving overall operational efficiency by refranchising. We have one market; we continue to look at some of that in, which is the UK. But the other markets, we feel fairly good about the way that the portfolio is stacked up at this point in time.
Okay. Next question is from Joe Buckley of Bank of America Merrill Lynch.
Joseph T. Buckley – Bank of America Merrill Lynch
Thank you. Can you talk about your comments like gaining share in the first quarter, particularly the U.S., what you think the gap between your comp number and the QSR sector might have been? And then extend that into April, I guess, the April sales commentary is a little bit more surprising given the easier comparison. So could you talk about factors that you think are influencing the April sales number?
All right, Joe. I think we’ll talk probably a couple of different things. One, it will be from a U.S. perspective and the other is really a global perspective. In the U.S., if you look at our comparisons to the overall competitive set, we’ve outperformed the competition by about 1.4%. That's the comp gap. And so we and that’s the overall competitive set. So we feel, again, that the things that we have begun to do to bring energy to the marketplace in both food and value. They are solidified, they are in place. Having said that, and we normally don’t talk about weather at all, but we know in the month of April, last quarter – the first quarter of last year, we saw very favorable weather. Matter of fact, it was the best weather that we had seen in 118 years, the first quarter, through March of last year.
This year what we’re seeing in the month of or the first quarter was some tough weather. We also in April, clearly, we’re seeing some differences in weather. So we have to be cognizant of that. We won’t use weather as an excuse because next year we don’t want to use it, we’re going to be comping up against it. But the reality of it is we have seen some things in weather that are there.
We still feel like from a competitive set, we’re going to perform well and our marketing plans and our food – and food promotions actually are really solid. We have brought better food news and stronger value to the marketplace.
Next question is from Keith Siegner of Credit Suisse.
Keith Siegner – Credit Suisse Securities LLC
Thanks. Just a follow-up on that question a little bit, thinking through the headline global April outlook, and how some of these issues in China and other parts of Asia might be factoring in. I mean, there’s a big information kind of vacuum right now about what’s actually going on in China with chicken and other counties that might be really influencing that. If you could talk a little bit about what might you actually be seeing there and how that plays into the preliminary global April outlook? That would be very helpful. Thank you.
All right, Keith. I’m going to ask Tim Fenton to talk a little bit about China, because as we talk about global, our overall global sales in terms of April, there are somethings that have been emerging pieces that we’ve seen that we had not seen before. One of those is avian influenza and I’ll ask Tim to kind to give a little update on that and maybe even talk just a little bit about. We’re coming out of one thing, which was the chicken industry and issues around antibiotics, and now we have a different piece, which is broader in impact, which is avian influenza. And so that does bear on our global sales as we look forward into April. So, Tim, if you would?
Sure, Keith, good morning. Yes, on China, as we stated, we had a sales decline of 4.6% in the first quarter, going up against a tough first quarter last year as far as high comp, but definitely we saw a switch out of chicken consumption. Fortunately, we do have other proteins that we were able to shift people into, but as we were coming out of it and gaining some traction, obviously, came the avian influenza, which we’ve been there before unfortunately and it not only has had an impact on China, it does have a potential impact on a lot of APMEA, not just China. But again, we continue to move on the different proteins that we have with beef and fish, and as course breakfast in McCafe, but we’re moving with it. We’re doing what we have. We’re continuing to look at what we do in the restaurants from a food safety and with our suppliers, and we’ve been there before, and we’ll continue to move forward with our plan.
Next question, Matt DiFrisco of Lazard.
Matt J. DiFrisco – Lazard Capital Markets LLC
Thank you. I guess, just touching on some of those food promotions, Don, you were talking about earlier, relative to prior years, I guess, a lot of people have looked at in the success of your beverage product, it had multiple years and sustainability and the impressiveness of lapping big comps and putting up big comps on top of that. Are you seeing the same, I guess, in this environment of more food promotional, it seems like they are a little bit more of an LTO-ish type environment or a sense that you’re not maybe holding the comp as much are they. Are you happy with that as far as how long you are – that you’re holding the lift from those new introductions such as the Fish Bites and some of the Premium Chicken Wraps?
Matt, great question. I think two different parts here, one is the LTO strategy and the other is those things that might become platforms and continue to be part of our course. So if you look at McWraps, McWraps for us is not a limited time offer promotion, it is one of those things that will be a platform for McDonald's as we move forward. It’s been that way in Europe and performed well. We are, we feel that the performance at these early stages in the U.S. has met the expectations that we have and so we are feeling fairly good about that. I continue to say, and I hedge a little bit on my comments about, we continue to feel great about it because let’s keep in mind, we’re still facing a slow recovery in United States from an overall economic perspective.
And as we look across Europe, we still have high unemployment rates and higher austerity measures, but in the U.S. that is a platform. Something a little different Fish McBites, that’s a limited time offer, so we’ll have that come in and go out. When you talk about beverages, we will continue to post in beverage products that remind our customers of the overall beverage line up. So when we say blueberry-pomegranate as a smoothie flavor, we’re also saying that we’re going to remind customers of pineapple-mango and strawberry-banana. So we’ll continue to do that and do it more aggressively this year than we did last year.
Next question is from Michael Kelter of Goldman Sachs.
Michael Kelter – Goldman Sachs & Co.
So your restaurant level margins now appear to be on pace for their third straight year of declines in all three divisions in the U.S., in Europe and in Asia. And so I guess there are two parts to my question on that point. The first is, what are the specific things you are doing to turn that around or is it really just waiting for same-store sales to get better? And second, how the franchisees reacted to declining profit margins at the restaurants?
Peter J. Bensen
Michael, it’s Pete. As we‘ve always talked that for us margins are much more of a top line gain. So driving comps is critical to driving those margins. And in this environment where you continue to have the cost pressures, so commodities will be up, labor rates are going up et cetera, and yet you have soft economics declining to flat eating-out markets, that battle for market share becomes so critical to the long-term health of the business that we’re willing to sacrifice a little bit of margin to maintain that traffic and grow the market share.
So in this environment, that’s how we’re going to continue to go after that, and around the world, we’re generally aligned with our franchisees around that. They understand the importance of driving traffic in this environment and taking market share, because again, if the industry isn’t growing, taking market share means we’re taking guests from other restaurants. And in that environment, that is what we have to do to continue to win. Would we love higher margin? Yes. Would they love higher cash flow? Yes, but in this environment, guest count growth and market share growth are critical.
Next question is from John Glass with Morgan Stanley.
John S. Glass – Morgan Stanley & Co. LLC
Thanks. Pete, just, and as you think about last year and this year to the point that it’s a tougher environment, earnings growth is slower, margins are under pressure. One of the things you have is a balance sheet that’s historically been very strong in the cash flow, which you’re using, but can you just reexamine what are the likelihood of you using this very low rate environment to increase leverage maybe without even changing your credit metrics, in other words, maybe the rates are just low enough that you’re going to add debt without changing your interest expense?
And secondarily, can you talk about maybe rethinking with the credit metrics you look at or the appropriate given this environment, maybe you’d like to extend that. If you could just maybe help us understand what is the credit metric you look and you manage to and then secondarily, if you’re willing to reexamine that?
Peter J. Bensen
John, that’s a great question. One of the things we’ve always talked about is the importance of maintaining our A credit rating. So you aren’t going to get into the specific measures that underlie that, but as we look at our role at the franchise or that financial strength is critical for us and you’re aware of our business model being co-invested with our franchisees and part of that three legged stool is a critical piece for us. So that credit rating is important and we feel the alignment created by maintaining that strong credit rating in our financial health is more valuable to shareholders than some kind of one-time leverage event would be.
That being said, as you’ve noticed each of the last few years, we continue to augment our free cash flow return to shareholders by increasing the debt on our balance sheet. And we will continue to do that again this year, but my guess is that it’ll probably be at a level below what we added last year.
Next question is from David Tarantino of Robert W. Baird.
David E. Tarantino – Robert W. Baird & Co.
Hi, good morning. Just a follow-up on all the margin commentary and the pressures that you’re seeing; Pete, could you give us an idea of what type of comp would be needed to hold on to either the restaurant margins or the EBIT – companywide EBIT margin for this year and maybe talk a little bit about how the greater emphasis on value is maybe changing or not changing that equation?
Peter J. Bensen
Yeah, David. We’ve historically said 2% to 3% comp would allow us to hold margin and we’ve kind of said that’s in a normal environment. And we’ve defined that as being commodity cost in that 2% to 3% range, but also getting half of that growth from average check and half of that growth from guest count. So when you’re in an environment today where we are going from, more of the sales growth is coming from guest counts than it is from check growth, that puts pressure on that equation. And we are seeing other cost increases in the labor line, additional deprecation, et cetera that are – that weren’t in our normal environment kind of calculation, which obviously points to a higher than 2% to 3% comp in this environment to maintain or grow the margins.
David, just another point, keep in mind please too also that the value aspect of our menu is still in the range of 10% to 15%. So we haven’t seen some huge upsurge relative to the mix of value-based products. The reason that you’ve heard us talk so much about product mix and new food news is because one of the things that we are doing around the world is ensuring that we have promotional food and new food that also is accretive to overall cash flow in the restaurants. And that also helps us quite a bit and that helps us to move average check.
A challenge that we have and we talked about in our earlier comments is the fact that if inflation is not as high, we don't have as much pricing power. And so when you think about the overall margin, clearly it's still demand, which we focus on the demand base, it’s still the average check components, pricing is a little softer in terms of what we can take and it's been the trade-up aspects, which is why we focus on the new menu aspects in our core in those larger sandwiches. So we are managing all of that and Tim is ensuring that around the world, those things are part of our plans.
Next question is from Will Slabaugh of Stephens.
Will E. Slabaugh – Stephens Inc.
Yeah, thanks, guys. I had a question on the product pipeline, and you mentioned a couple of items you rolled out recently. I wanted to just more broadly how you describe your pipeline now in terms of breadth of products and then also in the length of the timeline for rolling them out versus last year and then also maybe versus historically, if you would? Thank you.
I would – and I’ll ask Tim to also comment about some of the things that he’s seeing in some of the product pipelines around the world. I would tell you today, our product pipeline is more robust from a global perspective and the other aspect of this is, we are moving products around the world at a much quicker pace, which is also evidence of one of the questions earlier about limited time offers. It may appear that we have more of those only because you’re seeing some of the new food news that’s been coming from different markets around the world. But there are several products and platforms and product areas that we have felt – we feel like we’re in a pretty strong place with continue to develop, but, Tim, maybe some of the things you’ve seen across Europe and now in the U.S.
Sure. One of the strategies we’ve had is to really all the new products coming in 2013 to have at least 40% to 50% of them coming form our existing new product pipeline. Great products travel well across different borders and I think a good example is the McWraps right now that are going in the U.S., of course, to go in, in Canada shortly.
You compare second quarter of this year in the U.S., the last year we’ve got a very robust product line with the McWraps, the Blueberry Pomegranate Smoothie coming in. But we’re also seeing smoothies travel across the system in test in many countries in APMEA as well as in Europe. So I think overall, our overall product development, we’re doing more with existing products we had in different countries and really scaling those and we’re finding out that great products travel real easily across different country borders.
Next question is from Brian Bittner of Oppenheimer.
Michael Tamas – Oppenheimer Securities
Thanks. This is Mike Tamas on for Brian. Just have a follow-up on an earlier question. Can you just talk about the food margin kind of going forward? Should we expect the same kind of leverage that we saw this quarter or since inflation is going to pick up a little bit in the out quarters versus 1Q, which did actually look like a little deleverage here? Thanks.
Peter J. Bensen
Hey, Mike, it’s Pete. In my remarks I addressed that. We don’t typically give margin forecast. But we think the decline of a 130 basis points in this first quarter is about as bad as it could get this year and that subsequent quarters, we should see declines in our debt severe.
Next question is from Jeff Bernstein at Barclays.
Jeff A. Bernstein – Barclays Capital, Inc.
Great, thank you very much. Just two actual follow-ups on answers you previously gave. One, I was just wondering, Pete, you talked about kind of the balance sheet and taking on incremental debt over the past couple of years. I’m just wondering how you think about the balance of the dividend versus the share repo. It seems like dividend is higher up on the hierarchy. So I’m wondering why whether that’s considered to boost up significantly. And then the other follow-up was just the market share comment you guys made in terms of the U.S., I'm wondering if you can lay that in terms of how it looks in Europe. It sounds like UK and Russia might be slowing a little bit. We know Germany and France is already slow. So I’m just wondering whether your peers are suffering more than you or how you look at the gap between yourselves and them? Thanks.
Peter J. Bensen
Jeff, regarding the use of cash, nothing has changed in our philosophy. So after we invest in the business, we commit to returning all free cash flow to shareholders over time. And the dividend is our first priority and continues to be. And when you look at – going back to my earlier comment, when you talk about our credit metrics, one of the rating agencies looks at that dividend as a fixed commitment.
So as we continue to increase that dividend, that’s kind of added to our existing credit on our balance sheet which is one of the things that they limit to our rating in one of the agency’s models.
All right, Jeff, relative to market share, if you looked at our top seven markets, we are slack to growing share in six of the seven. So, and this is something that we feel and again, I hesitate to use the word comfortable because we’re not comfortable with our results. But we feel that the plans are appropriate that our markets have put in place. And so we have actually been trending positively relative to gaining market share around the world and we know our plans are stronger in 2013.
Next question is from Jeff Omohundro of Davenport.
Jeff F. Omohundro – Davenport Securities
Thanks. I just wondered if you could discuss the domestic reimaging program both in terms results versus expectations, and the pacing of the reimage program. Does this macro environment impact franchisee’s receptivity to it? How do you think about that to the balance of the year?
Peter J. Bensen
Yeah, Jeff, we think we’re going to do about another 800 reimages this year in the U.S. That will as of the end of the year – as of the end of the quarter here, we’ve got about roughly 40% of the U.S. done interiors and exteriors. And that 800 that we have in the pipeline this year, those are committed, signed up deals that we have in the pipeline. So we have a pretty good line of visibility into that. And while, again, to my earlier comments, we’d love to see margins growing, and sales growing at a faster rate. But these reimage decisions are longer term business building decisions and not an individual quarter or two type decision. So we can’t turn them on and turn them off on a dime and I think it’s important that we continue to make progress on those.
And Jeff, this is Tim. Four weeks ago, the U.S. just had their Combined Manager and Operator Rally. They have it every other year out in Vegas where we have – you bring together over 18,000 owner-operators and managers and staff. I attended one of those and I can tell you that the interest and the energy on reimaging is as high as it’s ever been. A lot of positive comments, a lot of momentum going into it, so nothing is – the energy has not waned off at all, if anything it’s moving forward.
Next question is from Jason West of Deutsche Bank.
Jason T. West – Deutsche Bank Securities, Inc.
Yeah, thanks, guys. Just going back to the question around the IEO markets around the world, I just want to understand the commentary. Are you guys saying that you’ve seen another leg down in sort of the overall macro in certain places like the UK and Russia or is it just sort of stabilized at a low level, if you could talk a bit more about the trend there? And then when do we lap kind of the slowdown that we saw last year? Has that happened yet in some of your core markets or is that really something that we haven’t lapped yet and we could get to that maybe May, June timeframe?
Hi, Jason. Just a couple of pieces on the IEO. So if you’re looking at overall IEO projections in terms of 2013, of those same seven markets that I talked about, four out of those seven markets are contracting. When you expand that outside of the top seven markets into to, say the top 20 markets, you have another host of markets that are flat or contracting. So we’ve got quite a few markets there where we see the IEO not growing at what we would consider to be an aggressive pace or a more healthy pace. Even those that are growing typically are growing maybe in the 1 percentile range. And so IEO has been soft in terms of growth.
Having said that, we realize that our growth is going to come from taking market share and our plans whether they’d be value based, whether they’d be new product based, the operational execution satisfying the needs of customers each and everyday, opening up our operating hours and windows, all of those things are fashioned at us capturing more market share.
Next question is from Andy Barish of Jefferies
Andy M. Barish – Jefferies LLC
Hey, guys, a quick question just trying to get a sense of recent trends. It seemed as if mix was negative and then if you kind of look at the first quarter numbers where you talked about negative traffic and pricing of roughly 0.5 or maybe a little bit more, it seems like mix was flat to maybe even a little bit positive, even with the reemphasized value focus. Is there something that’s changed here or something additional that I’m missing?
Peter J. Bensen
Andy, it’s Pete. The mix across kind of all of the three major geographies was down slightly in the first quarter. So we had as you indicated, we had the price, which was positive, we had a slight drag from mix, and the slight drag from the guest counts.
Next question is from Mitch Speiser of Buckingham Research.
Mitch Speiser – Buckingham Research Group, Inc.
Great, thanks very much. And I just want to ask a question about the global high yield market, whether it’s the top ten markets that you’re in or the top 20. When we think about it, is it just truly cyclical as the reason why it’s flat to declining? Could you may be talk about if there is any structural issues as well? It just seems like eating out it seems to be what people do as economies improve. Yes, the economies are soft, but if there is any competitive issues or any structural issues that are limiting the global eating out market from growing? Thanks.
Hi, Mitch. I don’t know if I would call them structural. I will call them basically just human behavior and consumer behavior. consumer confidence is down in many of the markets around the world. And as a result, when consumer confidence is down, clearly, then discretionary spending is typically down. And so when we look at whether it’d be, again, the U.S. with slower recovery, if we look at the last retail sales reports that we had, those being softer, GDP revisions around the world across Europe, still high unemployment rates across Europe, particularly teen unemployment rates, many of these things are the reasons that as we went through last year, we talked about trying to solidify value messages last year so that as we came into this year, we would not see further erosion to Pete’s point earlier.
Having said that, we still need top line basically to help us deliver in terms of the margin as Pete pointed out earlier. But there’s nothing structural, I would say, it’s just consumer confidence is softer. The only that is outside of that is when you look across APMEA and you look at 60% to 70% of our consumers in that geography favor chicken as a protein, particularly in markets like China and Japan, some of those Asian markets. And you have scares like avian influenza or antibiotic issues and food safety issues; then clearly that impacts our business. but those are shorter-term impacts; they’re not structural as well.
So, I think what we’re faced with is whether or not overall local economies and macroeconomies will start to trend better. When that begins to happen, we’re in a good position to benefit from it.
Next question is from Jeff Farmer of Wells Fargo.
Jeff D. Farmer – Wells Fargo Advisors LLC
Great, thanks. Sorry to do this, but I did want to take another crack at margins. It looks like the U.S. has seen something like three consecutive quarters of, I guess, roughly a 140 basis points of pressure. I’m just curious what color you can provide on the pressure resulting from things like the heightened focus on promoting values, softer same-store sales, even the commodity and labor pressure. And I guess the alternate question here is which of those three have had the greatest influence on that margin pressure?
Peter J. Bensen
Yes. as Don alluded to this earlier, the value component of our sales in the U.S. continues to be at a relatively similar position. So it’s not as if our Dollar Menu percentage has gone from 13% to 14% to 20%. It has remained relatively stable. What you do see sometimes in these softer economic environments is a little bit in the mix. So I mentioned the product mix was slightly negative to the sales. But we do have a fixed cost base in there that if you aren’t generating the comparable sales, the fixed cost from our management labor from our depreciation, from our third-party rent that obviously is impacted.
And if you look through the categories, there is not one of those expense categories that particularly jumps out as being so much more significantly larger than any of the others. So across all of those kind of categories I mentioned, 10 to 20 basis point impact when they’re all going in the same direction, because you can’t leverage the comps, that’s where you get the larger pressure.
And Jeff, if you – going back to Pete’s comments earlier relative to price, he mentioned that one of the price increases from last year at about 120 basis points came off. We replaced that with about 60 basis points. The reason for that is, because consumers are very sensitive to price. And so we don’t have the inflationary environment or the consumer sentiment environment to go out and take the same kind of price increases that historically we did. We do believe that this is not a structural kind of a change. We think that it is based upon the economy at this point. The second point I’d make is, when we think about trade-off, things like McWraps, products like McWraps, thus far in the month of April and as we’ve launched this product, we’ve been driving awareness.
So you’ve seen a lot of things in the marketplace with $2 McWraps and different things to try to get those in the hands and mouths of customers. As we move forward, it goes to the full price, which is in the $4 range. So, while we may not get the same unit movement, we will have and see a little bit better margin on that product.
So these are all other things that go in a hopper as we continue to manage both margins and also sales success without having guest count erosion.
Next question is from John Ivankoe of JPMorgan.
John W. Ivankoe – JPMorgan Securities LLC
Hi, thank you. Just that, I think a slightly different take in what’s been a pretty consistent theme overall margins. There is a really interesting sentence actually in, basically the front of your press release that says the U.S. is focused on menu and convenience initiatives to drive sales and restaurant profitability.
And it’s that restaurant profitability piece that I think is interesting, because it almost suggests that that you’re planning on growing restaurant profitability in 2013 in the U.S. while increasing attention on the Dollar Menu and especially increasing attention on the Dollar Menu with some of your competitor have by that definition, backed off. So that’s something that I want to get a sense of is, did franchisees push back on you saying that, the 2012 store level cash flow is something that they don’t want to see go down anymore, it’s kind of the first point.
And then secondly, just thinking about from a company store perspective, from a McOpCo perspective, do you think 2013 is a year of investment on the consumer to allow margins to go down willingly or should we expect at the end of the year that restaurant profitability can actually be up?
I’ll ask Pete to touch based on both points relative to the cash flows and also just the overall notion on restaurant profitability.
Peter J. Bensen
Yes. John, actually in 2012 owner-operator cash flow was up in the U.S. So this is not – what we try to convey with that kind of was the fact that while yes, it is a market share battle out there and we know that growing traffic in that environment is very important. And we know that price sensitivity is a little greater. At the end of the day, we’ve got a line-up of products over the summer and the rest of the year that have the potential to improve where we are relative to the first quarter.
So, again, in my remarks, I said that while the margin declined to 130 basis points in the first quarter, we expect as move throughout the year that the decline should be less severe that in part is driven by the expectation also that the sales comparison get easier. So implying that we expect because of the sales comparison is easing, we’ll get a little bit more of that top line leverage. And we’re not at a point where we’re going to say that we’re going to get enough leverage to actually kind of grow the margins, but it’s still going to continue to be a market share battle and we feel good as Don said about our product line-ups and our ability to drive some more sales.
And John, this is Tim. Just to add with the new products coming with wraps and beverage and breakfast, all higher margins for us as well as focus on beef going on for the second half of the year, all higher margin products.
Next question is from Sara Senatore of Sanford Bernstein.
Sara H. Senatore – Sanford C. Bernstein & Co. LLC
Thank you. Just a two follow-ups if I may. One is on the top line and it was something, I think that Pete just said about the idea that improving trends against easier comparisons. We didn’t really see that in April, even though comparisons I think are substantially easier than in March. And I guess, I wanted to talk about, when you’re framing that in that context. So I guess what I’m hearing is that, comparisons get easier, we wouldn’t expect to see sort of a symmetrical bounce back versus last year, but maybe just some incremental improvements sequentially. I just wanted to clarify that outlook.
And then the second follow-up was on China. Some other margin pressure in APMEA obviously is coming from new unit growth in China. I would have thought with the push towards more developmental license and franchising that we would – that that would diminish, is that a reasonable expectation going forward or is that drag going to persist for a while?
Hi Sara, I’ll take the shot at the first part, and then Pete will answer you at the second part of your question. So relative to April, here’s the things that we’re seeing out there. We understand the existing issues that have been there. We understand the slower recoveries I mentioned earlier. we understand some of the more consistent macroeconomic pressures that pressure consumer confidence. So, as we rolled through the first quarter and as we move into April, we expect some of the high comps that we have, we’re rolling across those.
So on that end, we feel better about the overall environment moving forward. Having said that, those macroeconomic pressures still persist and we’re seeing emerging issues that pop up, things like again, we mentioned avian influenza. We’re continuing to see some of the unemployment levels that have continued to increase. Some of the economies are worsening a bit, i.e., France, I mean, they’re seeing the worst economy since World War II. So we’re seeing certain aspects that are worsening a little bit. What does it mean for us? It simply means that the exact plans that we have today, we have to focus on those and focus even harder and we’ve got those inherent in the plans that we have around the world.
So we see some positives that are occurring. We see some potential negatives that are occurring, and ours is just to continue to emphasize the plans that we have in place to be able to continue to drive consumers or bring consumers into restaurant and drive business performance forward.
Peter J. Bensen
And Sara, regarding the new store margins and our franchisees, we only have 151 of our restaurants franchised in China, so compared to our base of over 1,700. So it’s less than 10% of our restaurants that are franchised there. So, while yes, directionally, that is a positive, it’s still relative to the base not going to be a significant driver. But as I mentioned, there is a lot of work going on around what is the optimal cost to operate those new restaurants. So as we look at the investment levels, making sure that we’re sizing the investment for the current sales opportunity, yet leaving the flexibility there to build for future demand as those trade areas grow. So that it’s getting a lot of focus and attention and as we, as you know, with comps being negative in the quarter, that is a continued drag not only on the new stores, but on all the stores there.
We have time for one more question, which will be from R. J. Hottovy of Morningstar.
R. J. Hottovy – Morningstar Research
Thanks, guys. Just wanted to ask a quick question about APMEA and specifically, Japan. Really in your mind, what will it take to get that market turnaround, especially now that we’re lapping about two years of negative results in the territory as well as some reports of some price increases in the region, just wanted to get a sense of your outlook for Japan in particular?
Yeah. This is Tim, R.J. First of all, Japan has been one of our most difficult IEO markets as far as negative IEO. We took it on as a special projects just going and really evaluating and segmenting our business. We have revamped our value campaigns, our product lines, and actually have seen a good trending force is trending up in the last couple of months is you’ll read soon.
As far as the pricing, I think what you may have read and it was a little bit taken out of context. We are adjusting some prices on our value menu if you will, bringing up a hamburger and a cheeseburger, at the same time, balancing out and bringing down the price of regular fry and some other products. I think the overall price increase and we haven’t taken a price increase since 2008 was just a little over a 1% blended. But a very difficult market, we are encouraged what we’re seeing as of late on changing some of the trajectory of the business.
All right. we’re about out of time. So I’ll turn it over to Don who has a few closing comments.
Well, thanks everyone again for participating with us this morning. And as we wrap up the call, again, really want to appreciate the questions and your thoughts and support of the business. We remain committed to our long-term strategies as we make thoughtful and strategic decisions to mitigate what we hopefully have informed you of, relative to short-term pressures in these challenging times.
Notwithstanding these pressures we’re experiencing today, we remain very confident in our future. We have defensible competitive advantages, a resilient business model, and the alignment across our owner-operator suppliers and the company teams to drive enduring and profitable growth for the long-term for our system and our shareholders despite some of the challenges that are being represented and we see around the world. So we remain confident and again, thanks for your participation this morning. And have a great day everyone.
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